Index Construction and Management: Decisions to Make | CFA Level I Equity Investments

In our last lesson, we learned that a market index represents the performance of a market, using constituent securities. However, index construction and management are not that simple. An index provider needs to make five key decisions:

1. Target market
2. Selection of constituent securities
3. Weight of individual securities
4. Index rebalancing
5. Index reconstitution

Let’s examine each decision more closely.

1. Target Market

The index provider must determine the target market the index aims to measure. This can range from broad markets like “stocks in the United States” to narrower markets like “small-cap value stocks in the United States.” Target markets may also be defined by asset class, geographic region, or other characteristics like economic sector, company size, duration, or credit quality.

2. Selection of Constituent Securities

After identifying the target market, the index provider must select the constituent securities from the target market. While it’s possible to include all securities in the market, it often makes more economic sense to select a representative sample. Some equity indexes fix the number of stocks to be selected, like the S&P 500 and FTSE 100.

The selection process can be determined objectively using criteria like the number of shares outstanding, the number of shareholders, and market capitalization. Alternatively, it can be determined subjectively by a committee.

3. Weight of Individual Securities

Once the constituent securities are selected, the index provider must determine the weighting scheme for each security. Common weighting schemes for stock indexes include:

• Price weighting
• Market capitalization weighting
• Equal weighting
• Fundamental weighting

Price-weighted indexes are calculated using the arithmetic average of the prices of the securities. Higher-priced stocks have more weight, but the price of a stock has no bearing on how large a company actually is. The Dow Jones Industrial Average is a well-known price-weighted index.

Market-capitalization-weighted indexes use weights based on the market cap of each stock as a proportion of the total market cap of all the stocks in the index. The S&P 500 Index is an example of a float-adjusted market cap-weighted index.

Equal-weighted indexes calculate the arithmetic average return of the index stocks. The Value Line Composite Average is a well-known example of an equal-weighted index.

Fundamental-weighted indexes use weights based on firm fundamentals like earnings, dividends, or cash flow. These weights are unaffected by the share prices of the index stocks.

4. Index Rebalancing

Rebalancing adjusts the weights of securities in a portfolio to their target weights after price changes have affected the weights. Price- and market cap-weighted indexes adjust their weights through price changes, while equal-weighted and fundamental-weighted indexes may require periodic rebalancing.

Rebalancing involves selling over-weighted securities and buying under-weighted ones, which can create high transaction costs and decrease portfolio returns. Some portfolios may choose not to rebalance as frequently to reduce these costs.

5. Index Reconstitution

Reconstitution is the process of updating the index constituents due to changes in the market, such as mergers, acquisitions, or bankruptcies. Reconstitution can also occur when the index provider believes that certain securities no longer represent the target market, or when new securities better represent the target market.

Some indexes have predetermined reconstitution schedules, such as annually or quarterly, while others follow an event-driven approach, reconstituting whenever a significant event occurs. Reconstitution can lead to higher transaction costs due to trading necessary to align the index with the updated constituents.

Conclusion

In conclusion, index construction and management involve a range of decisions, including the selection of target market, constituent securities, weighting schemes, and rebalancing and reconstitution procedures. Index investing can provide investors with a cost-effective way to achieve diversification, but it also has its drawbacks, such as the inability to outperform the market and potential tracking errors.